Value trap can become a ‘nightmare’

Francesco Curto
has a thing for value. The global head of Deutsche Asset and Wealth Management’s CROCI – cash return on capital invested – arm, challenges concepts of value all the time.

“What we have been arguing since the 1990s is financial statements don’t serve investors.

“It’s a long time to wage a war on accounting. But value investors are used to doing things the hard way. The real value investor sometimes goes a bit against the tide.

“For real value investors, the best time is when people are scared because you’ll find that people say ‘the euro is going to collapse’ and in 2008 you found plenty of value. You want something to be ugly. At the moment, there is not a lot of stuff that looks ugly."

He remembers the anticipation around the launch of the euro and the realisation among analysts that Europe had no singular market for financial services. Indeed there were 16 markets, and it was difficult to compare ­valuations of companies spanning the newly unified monetary zone.

“All of a sudden you’re going to be allowed to have free transfer of capital across Europe – you need to have a rosetta stone," he recalls.

Identifying value

He thinks the CROCI methodology goes some way toward solving that but its real purpose is the elusive goal of identifying true value in global companies. “My nightmare is a value trap and a value trap comes because I may think something is cheap but it’s not," he says.

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Curto, who is London-based, highlights some of the calls CROCI has got right such as American Airlines, for which its most significant assets and ­liabilities were off balance sheet.

“You need to capture these because the most important asset for American Airlines is the aircraft."

It filed for chapter 11.

Over 10 years (2004 to 2014) a $US100 ($110) investment in CROCI’s US index would be worth $US253, compared with $US194 for the same investment in the S&P 500. A ¥100 ($1.07) investment in the CROCI Japan index would be worth ¥143, compared with ¥125 for the TOPIX 100 Index.

“Accounting standards are not ­created for the real investors. There has been a move in the market to try and recognise the importance of more transparent financial statements so for example they’ve been talking about bringing some of the leases back on ­balance sheet. But coming from a ­situation where this has been ingrained in ­practices for a long time, it’s ­something that is ongoing."

Costly

Generally, utilities, telecoms, energy companies and materials are more expensive under CROCI analysis compared with a price-to-book-based or even price-to-earnings-based measure than technology and healthcare stocks.

Transparency of financial statements is an even bigger problem in emerging markets. And that’s before taking into account the distortive impact of inflation, which can be prevalent in emerging economies, and their tendency to turn to stimulatory policies.

“Many people think that the Russian market is very cheap but in reality it’s not as cheap as it looks . . . It’s a bit of a technical point but the issue is earnings come after depreciation and depreciation is supposedly capturing the ­consumption of the capital in a specific year to generate a specific amount of revenues. If you are a real investor, what you want to know is ‘what is the consumption of capital in today’s money?’

“If you live in a high inflationary ­environment, to replace these assets you bought 10 years ago is going to cost you much more," he said.

It’s an issue that comes up with ­mining companies that rely on ­expensive equipment. “To replace that 1 billion is going to cost you 2 billion or 1.5 [billion] depending on inflation."

The other problem with emerging markets is that in the last seven years they have more than doubled the amount of capital invested “but the real profitability has collapsed," he argues.

Earnings not growing

“The net result is that your earnings are not growing anywhere. This is one of the primary reasons for the troubles we are seeing today in emerging markets. It is about their inability to grow revenues in line with capital invested."

Curto says in theory, this calls for either revenue growth or a slowing down of the capital invested.

“What you see in emerging markets is every time there is a slowdown in the economy, they try and stimulate the economy with more investments and that is making the problem worse. You are ­creating a lot of capital in the system which is not productive."

Curto professes to have a “beautiful data base" covering 800 companies including some of the big ASX 200 stocks. His background is in academia but he sees parallels between academic pursuits and working in the research department of an investment bank.

He is also on a mission to master the 2000-year old dialect of where he was born in southern Italy. “My first ­language was not Italian, it was a ­dialect. It’s just sort of going back trying to understand who you really are. For the sake of progress we are forgetting our regions and finding there is a lot of interesting things going on in the past."